London, 11 November 201§0

The California State Teachers Retirement System (CalSTRS) has drastically scaled back its plans to invest in commodity derivatives, in response to recent concerns about the under-performance of commodity indexing strategies and the risk that large allocations could distort food and energy prices.

The No. 2 U.S. public pension fund will put just $150 million in commodities derivatives during the first 18 months of a three-year pilot programme, according to proposals put to the investment committee last week. The fund had been expected to put as much as $2 billion into the sector.

CalSTRS has $138 billion in assets under management. Commodity professionals had hoped the fund would give a big endorsement to the use of the asset class by approving a substantial allocation.

In September, CalSTRS staff put two options to the investment committee. The preferred option would have put commodities into the fund's absolute return asset class with an allocation of up to 1.5 percent of the total fund (equivalent to about $2 billion) to be gradually invested over the course of three years.

As an alternative, the staff recommended "incubating" commodities within the innovation portfolio with an allocation of $300-500 million over the same period. Now the staff have cut their recommended allocation to just $150 million over 18 months in the incubator program. Then, the program would be reviewed and the size of the allocation could be increased further if it was found to be successful.

ENHANCED INDEX STRATEGIES

Under draft proposals put to the investment committee on Nov. 4, CalSTRS will avoid a passive indexing approach owing to concerns about the cost of negative roll yields. Instead, the fund will allocate up to $100 million each to three managers employing enhanced indexing strategies or similar forms of dynamic risk management.

Enhanced indexers use futures and swap to follow an indexing methodology -- but are allowed to deviate slightly from the standard index weights to cut volatility and boost returns.

Investment managers' performance will be benchmarked against the Dow Jones-UBS Commodity Index but they will be expected to beat the index by at least 25 basis points per year.

CalSTRS cites a study by Hermes Investment Management showing that giving managers an active risk budget of as little as 3 percent can double returns from 7.1 percent a year to 16.4 percent, while trimming annualised volatility from 18.2 percent to 17.6 percent.

The Dow Jones-UBS Commodity Index has been selected rather than the more popular Goldman Sachs Commodity Index because of its smaller weighting toward energy and greater exposure to industrial metals and farm products. The GSCI's heavy weighting to crude oil and refined products gives it a better correlation with consumer price inflation and makes it a better hedge for the pension fund's liabilities. But the persistent contango in oil futures has led to large losses.

As a result the GSCI has become very easy to beat and there are concerns it does not justify the management fees and performance incentives demanded by investment firms.

In contrast the DJUBS index has held up better and is more challenging. Even so, CalSTRS will use its size to drive a hard bargain. It expects to pay management fees of only 0.3-0.9 percent per year, and performance fees of 0-10 percent.

PLAIN VANILLA -- AT LEAST AT FIRST

In the first 18 months, CalSTRS will restrict investments to long-only futures-based strategies. The fund's staff concedes that there could be benefits from a fully active long/short strategy that takes long positions in bull markets and tactical short positions in bear markets.

There are fears such strategies mostly try to generate alpha-based returns and have less correlation with inflation. After the first phase is completed, the staff may recommend including long/short strategies in the programme, or even direct investments in commodities and commodityassets such as pipelines through limited partnerships and master limited partnerships (MLPs).

CalSTRS' advisers remain convinced commodities are a useful addition to the portfolio and will help offset the negative impact of inflation. They cite work by Barclays Capital and Nobel Economics Laureate Paul Krugman to dismiss complaints that long-only investments by "massive passives" drove commodity prices higher during 2007-2008 and triggered food riots.

"CalSTRS is expected to have no impact on commodity futures markets" and "does not plan to invest in passive long-only vehicles" according to the report. Nonetheless, CalSTRS has been the target of a fierce lobbying campaign by interest groups opposed to fund investment in commodities and is clearly sensitive about its potential effect.

The report promises "Staff intend to invest gradually and prudently utilizing a number of investment vehicles while assessing its market impact and mitigating negative side effects when feasible". In reality, while the programme will start small, it will probably lead to significantly larger investments in the future, perhaps up to $1 billion or more.

Quantitative easing, growing commodity demand and narrowing contango structures in oil and other markets, together with genuine physical shortages, should ensure returns over the next 18 months are higher than they have been over the last 2-3 years. It will provide a very persuasive backdrop for CalSTRS to increase its portfolio allocation when the programme is reviewed in H1 2012.

Ends --

By John Kemp, Reuters market analyst - for Commodities Now.

The views expressed are his own.